The Fed and Inflation Expectations

Rarely a day goes by when we do not see a complaint about inflation and the Fed.  Some observers feel that the Fed will soon be forced to recognize their special insight--something that they know about inflation, but the Fed and the market do not.

Since current data are backward-looking and the Fed Open Market Committee is concerned about inflation expectations, the question of how to analyze inflation is quite important.  Predictions about future inflation are the best guide to Fed policy.

Professional Inflation Forecasts

The Econocator site is relatively new, but posts a lot of interesting and objective information on economic indicators, including this interesting study (hat tip to Abnormal Returns for the typical great job in citing important links).

The study looks at various econometric methods of forecasting inflation but concludes that opinion surveys do better than the forecasting methods.  So what do the forecasts show now?

A check of the Livingston Survey shows that consensus opinion of those forecasters has the CPI gaining 2.6% in 2007 over 2006 and 2.3% in 2008 over 2007.  Checking the Survey of Professional Forecasters shows a forecast in core PCE inflation (the Fed's favorite measure) of 2.1%, year-over-year, for each of the next three years.

Conclusion

There are three important conclusions from this information:

1. The expectation of future inflation is close to the Fed's comfort level.
2. If the study findings are correct, these explanations are also the best prediction.
3. There is little evidence that inflation is spiraling out of control.

The current debate seems to center on core CPI versus headline CPI.  We will look at this specific issue more carefully in another article.

For the moment, the prediction that the Fed is "on hold" with current policy seems most accurate.  Astute investors interested in likely Fed actions should keep this in mind.  The idea that the Fed has actually succeeded in achieving reasonable future growth and inflation, avoiding recession, is still a contrarian notion -- one that offers great investment potential.

Comments

[oldprof]

Mike -
Thanks for the thoughtful comment. I agree that the reason inflation works so well is that it is usually aligned with interest rates.

Your point about the relationship breaking down with very low rates is a good one, something I have on the writing agenda.

When there was fear of global deflation a few years ago, the confidence in earnings expectation was even lower than it is now.

Thanks again,

Jeff

[Econocator]

Thanks for the kind words re Econocator, Jeff.

ps - greatly enjoyed your recent, well balanced comments on the inflation debate.

[Mike]

Check out the chart on the following site (7th one down, entitled 'P/E Ratios & Inflation') for some relevant repercussions of this inflation figure--and how it relates to the Fed Model.

http://www.crestmontresearch.com/content/market.htm

What it shows is that P/E ratios tend to expand over 16 only when inflation is between 2%-3% (i.e. moderate).

Inflation impacts interest rates, and higher interest rates generally correlate with lower P/E ratios. Lower interest rates, conversely, generally result in higher P/E ratios. The data for the Fed Model, however, shows LOWERING P/E ratios when rates drop from 5% or so to a lower amount, seemingly contradicting the Fed model. So why is this?

To draw a conclusion that fits the data would no doubt earn me a well-earned reprimand from the old prof, so I'll offer a hypothesis instead. Let's use the 1930s as the chief counterexample to the Fed Model. Long-term interest rates were 1%. P/E ratios were also very low. Overall, economic conditions were depressed, as were people's moods. At the end of the 1970s, long-term interest rates were in the teens, and P/E ratios were very low. Overall, economic conditions were down (though not nearly as much as in the 1930s).

The 1930s was a period of deflation and low interest rates; the 1970s, high inflation and high interest rates. I would hypothesize that the overaching depressed mood of both periods led to compressed P/E ratios. People were not hopeful about the future.

Thus when interest rates drop below a certain level (around 5%), it's likely because the outlook for the future is no longer positive, resulting in lower P/E ratios.

Over the last year, P/E ratios have once again started to expand, but they're still below the average for periods of 2%-3% inflation. It's one of the reasons among many that I'm bullish on stocks for the next few years.

[Dboy]

Thanks for this blog entry. I agree with your conclusions.

Dboy

[oldprof]

Bill--

Your (continuing) objection is duly noted!

Thanks for your comment.

Jeff

[Bill aka NO DooDahs!]

I only find this tolerable if I export into Word and do "edit find replace" with "CPI" for "inflation."